Principles of Engineering Economic Analysis (Insert Course Name and Number) Insert Instructor's Name Insert Academic Term and Year

Principles of Engineering Economic Analysis
(insert course name and number)
Insert instructor’s name

Insert academic term and year
Principles of Engineering Economic Analysis, 5th edition

Background
• At various universities, this course is
referred to as Engineering Economy,
Engineering Economic Analysis, Economic
Decision Making, Economic Analysis, and
Economic Decision Analysis, among others
• The material to be covered is frequently cited
by alumni as the topic they want to see given
greater emphasis
• The subject will be approached from a cash
flow perspective, i.e., the concern will be with
monies spent and received (saved)

Course Objectives
Course objectives are for you to
 be prepared for the economic justification
portion of the FE exam
 be able to prepare economic justifications
for engineering proposals
 be able to manage personal finances and
make wise investment decisions
 be able to evaluate economic justifications
performed by others

Course Objectives
Other course objectives are for you to
 be comfortable using financial language
 be aware of tradeoffs involving expenses
and capital costs under tax and inflation
conditions
 be familiar with advanced techniques of
modeling decision problems under risk
and uncertainty conditions
 have fun!

My Commitment to You
I will endeavor to
 start and end class on-time every time
 be prepared and give a “best effort” in teaching
the course material
 treat you as professionals and cover material that
will be of maximum benefit to you
 determine your grade based on your performance,
i.e., you are not competing with one another
 return all graded work promptly
 respond to your feedback

Your Commitment to Me
You will endeavor to
 attend every class and arrive on time, unless you
are ill or have a personal “emergency”
 read the handouts and text before coming to
class; turn in all homework and take all tests
 conduct yourself as a professional, maintain the
highest integrity and code of conduct, and help
other students learn the material
 let me know if you have difficulty understanding
the material and provide feedback at the end of
each class on positive and negative aspects of
the course

The textbook for the course is
Principles of Engineering Economic

Analysis, J. A. White, K. E. Case, and D. B.
Pratt, 5th edition, John Wiley & Sons, Inc.,
2009.

BASIS FOR COURSE GRADE
insert something like the following
The course grade is based is based on homework
(10%) and the four highest exam scores (22.5% each).
AVERAGE GRADE
90 and above A
80 to 89.99 B
70 to 79.99 C
60 to 69.99 D
below 60 F

Chapter 1
Engineering
Economic
Analysis
Engineering economic analysis: using a
combination of quantitative and
qualitative techniques to analyze
economic differences among
engineering design alternatives in
selecting the preferred design

What Is Included in Chapter 1
1. The importance of the time value of
money (TVOM)
2. Four discounted cash flow rules
3. Ten principles of engineering
economic analysis
4. A 7-step approach for performing
engineering economic analyses
5. When the TVOM can be ignored

Fundamental Concept
Money has a time value

Time Value of Money
• Would you rather receive $1000 today or $1000 a year from
today?
today?
today?
today?
today?
today?
• Would you rather receive $1000 today or $10,000 a year
from today?
• Would you rather receive $1000 today or $100,000 a year
from today?
Time Value of Money
• Regardless of the value of inflation, money
has a time value due to its “earning power”
• Suppose you arrive in a city by airplane and
need a car
 you can buy a car
 you can rent a car
• Suppose you arrive in a city and need a place
to stay
 you can buy a house or condominium
 you can rent a house, apartment, or hotel room
• Suppose you arrive in a city and need money
 you can rent money from a business or person

Four Discounted Cash Flow Rules
1. Money has a time value;
2. Money cannot be added or
subtracted unless it occurs at the
same point(s) in time;
3.To move money forward one time
unit, multiply by one plus the
discount or interest rate;
4.To move money backward one time
unit, divide by one plus the discount
or interest rate.
Principles of Engineering
Economic Analysis
1. Money has a time value.
2. Make investments that are
economically justified.
3. Choose the mutually exclusive
investment alternative that maximizes
economic worth.
4. Two investment alternatives are
equivalent if they have the same
economic worth.

“If you need a new machine and
don’t buy it, you pay for it without
ever getting it.”
Henry Ford

Economic Analysis
5. Marginal revenue must exceed
marginal cost.
6. Continue to invest as long as each
additional increment of investment
yields a return that is greater than the
investor’s TVOM.
7. Consider only differences in cash
flows among investment alternatives.

“The object of management is not necessarily
the highest rate of return on capital, but … to
assure profit with each increment of volume
that will at least equal the economic cost of
additional capital required.”
Donaldson Brown
Chief Financial Officer
General Motors
1924

Economic Analysis
8. Compare investment alternatives over
a common period of time.
9. Risks and returns tend to be
positively correlated.
10. Past costs are irrelevant in
engineering economic analyses,
unless they impact future costs.

Economic Justification
Seven Questions to Answer
What investment alternatives are available?
What is the length of time over which the
decision is to be made?
What TVOM will be used to move monies
forward and/or backward in time?
What are the best estimates of the cash flows
for each alternative?
Which investment alternative seems best,
based on the economic criterion chosen?
How sensitive is the decision to changes or
errors in the estimates used in the analysis?
Which investment is recommended?
SEAT
Systematic Economic Analysis Technique
Seven-Step Procedure
Identify the investment alternatives
Define the planning horizon
Specify the discount rate
Estimate the cash flows
Compare the alternatives
Perform supplementary analyses
Select the preferred alternative
Step 1: Identify the Feasible Alternatives
 Most important step!

 Beware the “Do Nothing” alternative
 Consider a range of alternatives
 Be objective!
 Impact of “size gates”
 “Design the whole, justify the whole, and
implement the parts”

Example 1.5
A firm is considering three investment
proposals (A,B, & C). A requires $1M
investment, B requires $2.5M, and C
requires $3M. The firm has $4.5M to
invest. C is contingent on A; B and C
are mutually exclusive. The “do
nothing” alternative is not feasible.
Form the set of mutually exclusive
investment alternatives that exists.

Example 1.5 Forming Investment
Alternatives from Investment Proposals
Proposals
ALT xA xB xC Comments
1 0 0 0
2 0 0 1
3 0 1 0
4 0 1 1
5 1 0 0
6 1 0 1
7 1 1 0
8 1 1 1

Example 1.5 Forming Investment
Alternatives from Investment Proposals
Proposals
ALT x A x B x C Comments
1 0 0 0 "Do nothing" not feasible
2 0 0 1 Violates contingency
3 0 1 0 Feasible
4 0 1 1 Mutually exclusive
5 1 0 0 Feasible
6 1 0 1 Feasible
7 1 1 0 Feasible
8 1 1 1 Violates multiple constraints
Four alternatives: {B}, {A}, {A,C}, {A,B}
Step 2: Define the Planning Horizon*
 The width of the window

 U.S. < 5 yrs; Japan > 15 yrs
 Planning horizon vs. working life vs.
depreciable life
 Standard planning horizons
 Impact of too short a planning horizon
 Impact of too long a planning horizon
Principles of Engineering Economic Analysis, 5th edition * See Chapter 4

Step 3: Specify the Discount Rate*
 Hurdle rate, interest rate, return on

investment (ROI), minimum
attractive rate of return (MARR)
 Money has a time value!
 Opportunity cost for money
 U.S. – double-digit rates
 Japan – single-digit rates
Principles of Engineering Economic Analysis, 5th edition * See Chapter 4

Step 4: Estimate the Cash Flows*
 Examples of cash flows
 Depreciation is not a cash flow
 Annual cash flows
 “Best estimates”
 Tangibles and intangibles
 Future estimates, not past estimates
 Costs and revenues
 Incremental cash flows
 Don’t forget the competition!
Principles of Engineering Economic Analysis, 5th edition *see Chapter 16

Step 5: Compare the Investment Alternatives*
 Present worth method (PW) (* Ch. 5)
 Capitalized worth method (CW) (* Ch. 5)
 Discounted payback period method (DPBP)
(* Ch. 5)
 Payback period method (PBP) (* Ch. 5)
 Future worth method (FW) (* Ch. 6)
 Annual worth method (AW) (* Ch. 7)
 Internal rate of return method (IRR) (* Ch. 8)
 External rate of return method (ERR) (* Ch. 8)
 Modified internal rate of return (MIRR) (* Ch. 8)
 Benefit/Cost ratio method (B/C) (* Ch. 14)

Step 6: Perform Supplementary Analyses*
 GIGO
 Don’t wade in rivers, on the average, two feet
deep when wearing boots that are two feet
tall!!
 Breakeven analysis
 Sensitivity analysis
 Risk analysis
 Going the extra mile!
 Beware of “paralysis of analysis”

Break-even, Sensitivity, and Risk Analyses
 Break-even analysis
determining the value of one or more
parameters that will make the PW=0
 Sensitivity analysis
determining the impact of a range of values for
one or more parameters on the measure of
merit
 Risk analysis
determining the probability the PW>0, given
probability distributions for one or more
parameters

Step 7: Select the Preferred Alternative*
 Obtain the support of the users of the
recommended system
 Pre-sell the recommendation
 Eliminate surprises
 Do not over-sell the technical aspects of the
recommended system
 Technical aspects seldom convince
management to make the required investment
 The decision-makers’ perspectives are broad
 Know their priorities and tailor the economic
justification package accordingly

Step 7: Select the Preferred Alternative
 Relate the proposed investments to the well-
being of the firm
 Show how the investment relates to the firm’s
strategic plan and stated corporate objectives
 Your proposal will be only one of many
submitted and many will not be funded
 Failure to fund your proposal does not mean
management is stupid
 Management’s decision to fund your proposal
does not mean they are brilliant

Step 7: Select the Preferred Alternative
 Don’t confuse unfavorable results with destiny
 Timing is everything!
 Profit maximization is not always the “name of
the game,” but “selling” is!
 A firm’s ability to finance the proposal is as
important as its economic merit
 You get what you pay for
 Don’t be penny-wise and dollar-foolish
 Remember the “Golden Rule,” those with gold
make the rules!
 The less you bet the more you stand to lose in
case you win!

Weighted Factor Comparison of Alternatives
Example 1.8
Three investment alternatives (A,B,C) are being
considered by the Ajax Mfg. Co. The PWs are $25K, $20K,
and $18K, respectively. There are differences in the
quality (Q) of the tools being considered, the time (T) to
fill a customer’s order, and the reputations (R) of the tool
suppliers.
Factors Weights Rankings
A B C
PW: present worth 30 10 8 7.2
Q: product quality 35 8 10 5
T: fill time 25 3 10 7
R: supplier reputation 10 8 5 10

Weighted Factor Comparison Form
Company: Prepared by: Date:
Description of investment:
A B C
Factor Wt.
Rt. Sc. Rt. Sc. Rt. Sc.
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
Totals 100

Company: Ajax Tool Co. Prepared by: JAW Date: April 1, 2009
Description of investment: order picking equipment for distribution center
A B C
Factor Wt. Rt. Sc. Rt. Sc. Rt. Sc.
1. Present Worths 30 10 300 8 240 7.2 216
2. Product quality 35 8 280 10 350 5 175
3. Fill time, customer order25 8 200 10 250 7 175
4. Supplier reputation 10 8 80 5 50 10 100
5.
6.
7.
8.
9.
10.
Totals 100 860 890 666

Company: Ajax Tool Co. Prepared by: JAW Date: April 1, 2009
Description of investment: order picking equipment for distribution center
A B C
Factor Wt. Rt. Sc. Rt. Sc. Rt. Sc.
1. Present Worths 40 10 400 8 320 7.2 288
2. Product quality 30 8 240 10 300 5 150
3. Fill time, customer order20 8 160 10 200 7 140
4. Supplier reputation 10 8 80 5 50 10 100
5.
6.
7.
8.
9.
10.
Totals 100 880 870 678

When the TVOM Need Not Be
Considered
1. When no investment of capital is required
2. When all cash flows occur in a limited time
period, e.g., less than a year
3. When annual cash flows are roughly proportional
to cash flows the first year
4. When the same capital investment is required for
all alternatives
5. When there are no essential differences in cash
flows among the alternatives after the first year

Example 1.9
Six college students are making plans for spring break. They are
considering traveling 1200 miles to Florida by bus, train, plane, rental
cars, or rental van. Due to bus and train schedules, they limited their
options to plane, two rental cars, or a rental van.
The final data used in their analysis of transportation options are as

follows: round-trip airfare per person ($300); daily rental rate for each
car, all charges except fuel ($50); rental car gas mileage (20
miles/gallon); drop charge for each car ($150); daily rental rate for a
van, all charges except fuel ($80); rental van gas mileage (12
miles/gallon); drop charge for the van ($225); cost to travel to or from
the airport at the spring break destination ($50 per cab, two cabs
required); and average price of gasoline ($4.25/gallon). If they keep the
rental vehicle, the charges will be for 7 days; if they drop the rental
vehicle, the charges will be for 2 days.

Example 1.9 (Continued)
Alternatives
1. fly to/from spring break
2. use two rental cars and incur drop charges
3. use two rental cars and do not incur drop charges
4. use a rental van and incur drop charges
5. use a rental van and do not incur drop charges.
Economic Analysis
1. Total cost = 6 passengers ($300/passenger)
+ 2 taxis($50/taxi)(2 trips) = $2200.00
2. Total cost = 2 rental cars ($50/day)(2 days) + 4 drops ($150/drop)
+ 2,400 miles/car (2 cars)($4.25/gallon)/(20 miles/gallon) = $1820.00
3. Total cost = 2 rental cars ($50/day)(7 days)
+ 2,400 miles/car (2 cars)($4.25/gallon)/(20 miles/gallon) = $1720.00
4. Total cost = 1 rental van ($80/day)(2 days) + 2 drops ($225/drop)
+ 2,400 miles/van (1 van)($4.25/gallon)/(12 miles/gallon) = $1460.00
5. Total cost = 1 rental van ($80/day)(7 days)
+ 2,400 miles/van (1 van)($4.25/gallon)/(12 miles/gallon) = $1410.00

Example 1.9 (Continued)
Alternatives
1. fly to/from spring break P rinc iple #7
2. use two rental cars Con sid
ero nl
y differen cesin ca sh fl
ow s
a. incur drop charges am on g
investm en talternatives
b. do not incur drop charges
3. use a rental van
a. incur drop charges
b. do not incur drop charges
Economic Analysis
1. Total cost = 6 passengers ($300/passenger)
+ 2 taxis($50/taxi)(2 trips) = $2200.00
2. Driving cost = 2,400 miles/car (2 cars)($4.25/gallon)/(20 miles/gallon)
+ 2 rental cars ($50/day)(2 days) = $1220.00
a. Cost = 4 drops ($150/drop) = $600.00
b. Cost = 2 rental cars ($50/day)(5 days) = $500.00
Lowest cost = $1720.00
3. Driving cost = 2,400 miles/van (1 van)($4.25/gallon)/(12 miles/gallon)
+ 1 rental van ($80/day)(2 days) = $1010.00
a. Cost = 2 drops ($225/drop) = $450.00
b. Cost = 1 rental van ($80/day)(5 days) = $400.00
Lowest cost = $1410.00
Example 1.12
Hugh Kinney, a small business owner, must purchase a
large number of light bulbs for his new office building. At
Wal-Mart he found several options available, but narrowed
his selection to either GE Soft White 100 incandescent or
GE Soft White 100 helical fluorescent bulbs, costing 26¢
and $3.22, each, respectively. The light output per bulb is
1690 lumens and 1700 lumens, respectively; the energy
used per bulb is 100 watts and 26 watts, respectively; and
the rated life per bulb is 750 hours and 12,000 hours,
respectively. Usage is estimated to be 2500 hours/year.
Electrical energy costs $0.10 per kilowatt hour. Labor to
install/replace a bulb is estimated to cost $2.00. Which bulb
should he choose in order to minimize his annual cost?

Hugh’s Solution to Example 1.12
Energy cost/bulb:
Incandescent (2500 hr/yr)(100 w)($0.1/kWh)/1000 hr
= $25/yr
Fluorescent (2500 hr/yr)(26 w)($0.1/kWh)/1000 hr
= $6.25/yr
Acquisition, plus installation/replacement cost:
Incandescent (2500 hr/yr)($2.00 + $0.26)/750 hr
= $7.53/yr
Fluorescent (2500 hr/yr)($2.00 + $3.22)/12,000 hr
= $1.09/yr*
Annual cost:
Incandescent $25.00 + $7.53 = $32.53/yr
Fluorescent $6.25 + $1.09 = $7.34/yr
* violates 1st DCF rule, since bulb lasts longer than a year
Example 1.13
Stacy Kinney, an engineer and Hugh’s daughter, pointed
out several errors in her father’s analysis. She explained
that the energy cost consists of a fixed cost and a
variable cost: $7.10 per meter; 8.803¢/kWh for < 2000 kWh
in a month; and 8.8087¢/kWh for > 2000 kWh/mo. Since
the energy load on the building > 2000 kWh/mo, she said
the incremental cost would be 8.087¢/kWh, not 10¢/kWh.
Stacy also asked how the labor cost was determined.

Given the answer, she asked if the employee will be paid
overtime for installing/replacing bulbs. When she learned
he would not, she reminded her father that there would
not be an incremental cost to install or replace bulbs.
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Stacy’s Solution to Example 1.13
Energy cost/bulb:
Incandescent (2500 hr/yr)(100 w)($0.080871/kWh)/1000 hr
= $20.2175/yr
Fluorescent (2500 hr/yr)(26 w)($0.08087/kWh)/1000 hr
= $5.2566/yr
Acquisition, plus installation/replacement cost:
Incandescent (2500 hr/yr)($0.26)/750 hr
= $0.8667/yr
Fluorescent (2500 hr/yr)($3.22)/12,000 hr
= $6708/yr ($0.9883/yr based on 15% TVOM)
Annual cost:
Incandescent $20.2175 + $0.8667 = $21.0842/yr
Fluorescent $5.2566 + $0.6708 = $5.9274/yr ($6.2449/yr based
on 15% TVOM)

Pit Stop #1—Checking Your Pulse
• True or False: If someone offers you the choice of receiving $1000
today versus receiving $1000 a year from today, you should take the
money today if your time value of money is greater than zero.
• True of False: A strength of the weighted factor comparison technique

is its scientific foundation and its elimination of subjectivity from
decision making.
• True or False: If your time value of money is 10% annually, then you
will be indifferent between receiving $1000 today and receiving $1100
one year from today.
• True or False: Based on the principles of engineering economic

analysis, you should bet on the horse with the lowest odds to win,
because risk and returns tend to be positively correlated.
• True or False: Every economic decision should be based on the time

value of money.

Pit Stop #1—Checking Your Pulse
• True or False: If someone offers you the choice of receiving $1000
today versus receiving $1000 a year from today, you should take the
money today if your time value of money is greater than zero. TRUE
• True of False: A strength of the weighted factor comparison technique

is its scientific foundation and its elimination of subjectivity from
decision making. FALSE
• True or False: If your time value of money is 10% annually, then you
will be indifferent between receiving $1000 today and receiving $1100
one year from today. TRUE
• True or False: Based on the principles of engineering economic

analysis, you should bet on the horse with the lowest odds to win,
because risk and returns tend to be positively correlated. FALSE
• True or False: Every economic decision should be based on the time

value of money. FALSE

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Principles of Engineering Economic Analysis

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Principles of Engineering Economic Analysis, 5th edition

Principles of Engineering Economic Analysis, 5th edition

Principles of Engineering Economic Analysis, 5th edition

Principles of Engineering Economic Analysis, 5th edition

Principles of Engineering Economic Analysis, 5th edition

Principles of Engineering Economic Analysis, 5th edition